Break Up the Banks
From the April 5, 2010, issue of NR.


Arnold Kling

I am not optimistic that there is an easy cure for financial fragility even if we break up the banks. To the extent that they share exposure to the same risk factors, a system with many small banks could be just as vulnerable as a system with a few large ones. The fundamental sources of financial risk — including leverage, interest-rate risk, exchange-rate risk, and speculative bubbles — have a way of insinuating themselves regardless of the banking industry’s structure and in spite of the best intentions of regulators. But while no one can promise that breaking up large banks would make the financial system safer, it would without question make it less corporatist. Which returns us to the question of political economy.

In the United States, big banks provide an invitation to mix politics and finance. Large financial firms get caught between public purposes imposed on them by Congress and the interests of private stakeholders. If they do not maintain good relations with legislators, they risk adverse regulation. Therefore, it behooves them to shape their regulatory environment.

And they have done so. In recent decades, the blend of politics and banking created a Washington–Wall Street financial complex in the mortgage market. This development, and its consequences, have been well documented. Michael Lewis’s 1989 book Liar’s Poker includes a portrayal of the political exertions of investment bankers to enable mortgage securitization to take off. “The Quiet Coup,” an article by Simon Johnson that appeared in the May 2009 issue of The Atlantic, chronicles the rapid accrual of profits and power by large financial institutions over the past 30 years; during this period, Wall Street firms were able to shape the basic beliefs of political figures and regulators, a phenomenon that Brookings Institution scholar Daniel Kaufmann has dubbed “cognitive capture.” Andrew Ross Sorkin’s Too Big to Fail, which describes the response of the Federal Reserve and Treasury to the financial crisis, leaves the distinct impression that senior bankers had much more access to and influence over Washington’s decision makers than did career bureaucrats.

Notwithstanding the good intentions of policymakers, who no doubt plan to create a stronger regulatory apparatus going forward, large banks will inevitably have too much power for the apparatus to govern them. They will shield themselves from its attentions by making political concessions on lending practices. So long as big banking is conjoined to big government, that is, we risk a return to the regime of private profits and socialized risk.

I would prefer a completely hands-off policy when it comes to financial markets, but the political reality is that deposit insurance and regulation are not going away. Given that they are not, the worst possible outcome is that the marriage of politics and finance evolves into outright corporatism, as it did with Freddie Mac, Fannie Mae, and the rest of the nation’s largest financial institutions. And that evolution is directly attributable to the influence that comes from banks’ being big enough to achieve real political power. To expand free enterprise, shrink the banks.

Arnold Kling is an adjunct scholar with the Cato Institute and a member of the Financial Markets Working Group of the Mercatus Center at George Mason University. He is the author of Unchecked and Unbalanced: How the Discrepancy Between Knowledge and Power Caused the Financial Crisis and Threatens Democracy. This article first appeared in the April 5, 2010, issue of National Review.